By Brendan Conway

Those pesky hedge funds! Those nettlesome activist investors!

MKM Partners event-driven strategist Keith M. Moore this morning calls for regulators to take a closer look at activist investors’ use of hedging and sophisticated instruments such as swaps to increase their chances of success when locked in a struggle with a public company’s board and management.

We always thought it is good, on net, that Carl Icahn and friends can throw their weight around to unlock shareholder value. It’s a tall order to argue that just because an investor happens to be an activist, he should be barred from using the same widely used tools at others’ disposal, just by virtue of being an activist.

But insofar as these investors can use hedging to meaningfully change the incentives they face, such that they don’t share other shareholders’ downside risks, Moore may have a point.

The example he cites is Mason Capital’s fight against Canadian telecom company Telus‘ (TU). Telus wants to collapse its dual-share structure on a one-for-one basis. Mason opposes this. As Moore explains, it picked an ingenious means of fighting Telus while also hedging its bets:

In this case, an activist investor took advantage of the ability to hedge market risk by buying voting shares, while shorting non-voting shares. This technique allowed the fund to defeat the company’s attempt to convert to one class of stock without paying a premium for the voting shares.

A court in British Columbia decided that Mason’s’ interests weren’t comparable to those of the average shareholder. For certain, the strategy was nicely hedged. As Telus proclaimed in an early September press release:

The Court made a number of comments about Mason Capital’s empty voting strategy, including:

“When a party has a vote in a company but no economic interest in that company, that party’s interests may not lie in the wellbeing of the company itself. The interests of such an empty voter and the other shareholders are no longer aligned and the premise underlying the shareholder vote is subverted.”

The Court also said that only Mason stands to profit if the price spread between common shares and non-voting shares increases, and that “only Mason is indifferent to the overall value of TELUS itself.”

What do you think? Should the rules prevent a technique like Mason’s? Or is this more than a loophole, something that should be protected?

About Focus on Funds

As exchange-traded funds and other investing vehicles have ballooned in number, the task of figuring out what works well and what doesn’t has only gotten harder. Barrons.com’s Focus on Funds looks under the hood of ETFs, mutual funds and hedge funds for overlooked values, actionable ideas and the latest pitfalls for fund investors.